Too many investors operate on adages that deserve debunking or at least questioning. If you're in your 20s or 30s, you have time to correct some outmoded conventional wisdom before it does damage to your portfolio:
"Stocks for the long run" or "the markets always come back"
Of course these seem true when you consider the century-old bull market the U.S. experienced, but there are a lot of Brazilians and Russians that may take a slightly different view. (Granted, in such countries things do not always happen as they do in America; those countries nationalized publicly traded companies.) The Japanese market is down more than 75 per cent from its 1990 peak as I write this article in March 2011. The NASDAQ is still down 45 per cent from its March 2000 peak. There is no assurance markets will come back. And "the long run" is a relative term for each individual.
"Buy and hold" is how great investors such as Warren Buffett invest.
Anyone who has studied Warren Buffett knows he holds some securities long term, others in the mid term and short term, but rest assured there is no stock he will hold forever. Warren Buffett owned Freddie Mac and considered it one of great companies in the 1980s and 1990s. By the late '90s he noticed some trends in lending that gave him concern, and he sold his shares a decade before the company became the penny stock it is today. He bought PetroChina and sold it a few short years later when the stock's value exceeded any reasonable sense of value. Bottom line: Buffett is a risk manager buying good assets at fair prices and selling those assets at overvalued prices based on expectations or current valuations.
Don't sell now or you will lock in your losses.
During the Great Depression, many Americans wished they sold when they were down 10 per cent, 30 per cent, 50 per cent or even 70 per cent before the market hit bottom at 90 per cent down. This adage is a classic tool used by salespeople to stymie a client from selling out securities or transferring their account to another adviser. Salespeople such as brokers are collecting commissions or fees on these assets and want to keep them. Transfer your account if you think the person you are dealing with is not a true professional adviser. Who knows? Your new adviser may just make those losses back quicker and to greater profit than the one you dump.
Let your winners run and sell your losers.
This sounds like a good idea, but it misses the point. People who invest based on "momentum" are usually poor long-term investors. When momentum in one direction ends, the reversal can be quick, substantial and invisible. You need to understand your stocks and hold them only when the business is still sound and the valuation of the company is still reasonable.
You cannot time the market.
There is no doubt one cannot time the movements of the market. You may get it right 60 per cent of the time, but not much more. But, even though I believe you cannot time the market, you can determine when market risk has either escalated or been reduced. As an investor, you need to be a risk manager and not make dramatic moves; merely estimate the risk reward ratio of investment opportunities based on the price of the underlying securities, the global economic circumstances and the technical indicators.
Asset allocation, the efficient market and rebalancing
These are the latest concepts devised by academics and embraced by brokerages to help sell products. The concepts suggest one cannot add value to the market except by maintaining a good product mix. An analysis says if you maintain a 60 per cent stock and 40 per cent bond mix, you will have a 92 per cent chance of achieving your goals. Immediately you hope you are not unlucky enough to have the 8 per cent occur in your time. Second, the success ratio is calculated using historic data. Unfortunately, history only rhymes with the past and never repeats it. I have found historic information to be occasionally beneficial in determining investments, though.
For example, it was helpful to see how the market had lost ground in the six quarters starting October 2007. Historically there had never been a seven-quarter downturn, including the 1930-32 decline of 90 per cent; there was at least one or two up quarters in there. Because my other indicators were positive, I was comfortable predicting that the second quarter of 2009 would prove positive. But if the stock market in 2000 or 2008 is not in a very solid risk-reward position, why not move to a cash position for a while?
Lower your fees and make higher returns.
This is true if your only objective is to track the markets -- not always a wise idea, as we have learned over the past decade. Not to mention that many of the world's wealthiest investors have paid hedge funds 2 per cent per year and 20 per cent of profits. Why are the wealthy paying 10-fold-plus what the average index fund costs? The answer: For superior risk-adjusted rates of return. The point is not whether you should pay higher fees, but that talented advisers can be worth it even if they charge more than an index fund.
Andrew Tignanelli is president of Financial Consulate, based in Hunt Valley, Md., and a member of NAPFA, the National Association of Personal Financial Advisors.
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